Best to apply cash to credit card debt or down payment?
To Her Credit
Dear To Her Credit,
In a few months, my husband and I will be receiving around $7,000. With this money, we want to make smart decisions for our credit because we hope to become more financially stable so we can buy a house in the next year or two. What should we do with this extra cash -- pay off our credit cards or put it in savings? Our credit cards total around $5,000. Thank you! -- Meghan
Congratulations! I wish all of my readers had to wonder what to do with $7,000!
I'm impressed that you and your husband are not going out and buying a motorcycle, or making a down payment on a motor home. I'm sure you've known people who get $1 and spend $10! Saving for a home is a worthy goal and sounds like it is important enough to you that you will make a plan and stick to it.
If you want to buy a house in one to two years, you need three things:
- A down payment (usually 10 percent to 20 percent of the sale price), plus closing costs.
- A good credit score.
- An acceptable level of debt payments compared to your income (debt-to-income ratio)
We'll assume your goals are to save $15,000 and to pay off your credit card debt, both within two years. (I hope you live in an area where $15,000 can get you into a house. If you live in San Francisco or another high-priced area, you'll have to either save more per month or save a lot longer.) Let's further assume that you have $500 per month available to pay off debts or put into savings, and your credit cards have an interest rate of 18 percent.
Here are two different plans to reach your goals:
Plan No. 1
Put $7,000 into the interest-earning fund. Pay $500 per month on the 18 percent credit cards until they are paid off; then start applying the $500 per month to your fund.
In 11 months, your credit card balance should be $0, and you will have paid about $458 in interest. Now you can concentrate on building up your savings fund. After 26 months, you can have $15,000 saved to buy a home. Not bad!
Plan No. 2
Pay off credit cards immediately with $5,000 cash. Put the remaining $2,000 in a money market or mutual fund making with 4 percent annual interest and add $500 per month to the fund.
You should have more than $15,000 in the bank and no credit card debt in 25 months. You reach your goal a full month sooner by paying off the high interest credit card debt immediately and then diligently putting money into savings! Plus, you can save the interest you would have paid on the credit card debt balance.
What about making the minimum payments on the credit card debt?
Paying just the minimum is an expensive alternative. As you pay down the balance on your credit card, the minimum payment also goes down. If you never pay more than you have to, it could take you 313 months -- yes, that's 26 years -- to pay off that $5,000. In the meantime, you'll pay about $7,115 in interest expenses -- more than the current balance.
If you want to get into a house in two years, the fastest way to reach your goal is to pay off the credit cards and then start tucking money into a savings fund. By the time you have your down payment, your credit score will improve because you have more available credit and a perfect record of making payments. Plus, your debt ratio will be lower with no consumer debt. You and your husband should be in strong position to qualify for a mortgage.
Good luck as you work toward your goals, and I hope the two of you are house hunting soon!
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Published: September 4, 2009
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